Musings on minimizing taxes on investments


During 2012, one of my clients generated $50,000 of short-term capital gains by taking advantage of short-term swings in the market. That was quite an accomplishment!  However, since they pay tax of 33% (28% federal plus 5% state) on short-term gains, their tax bill on the gain amounted to $16,500. That is still a net gain of $33,500 ($50,000-16,500) after taxes…which is nothing to sneeze at!  But, as I pointed out to them, if they were to do that inside their traditional IRA, the $16,500 paid in taxes would still be in their IRA working for them.

Their question to me was “What if we incur losses? We cannot deduct those losses in our IRA. Is this still a good idea?”  Personally, I think moving investments that produce short-term capital gains into an IRA (and off your annual income tax return) is a great idea. However, it is not a great place for losses…but neither is your non-retirement investment account.

Let’s assume the worse…the market suddenly tanks and you incur $60,000 of losses before you can convert everything to cash. If the losses occur in your non-retirement account you would be able to offset $3,000 of those losses against your other income each year. You would also be able to offset future capital gains (long-term and short-term). However, if the losses occur in your IRA, there is no $3,000/year deduction available. But, if you never recoup those losses, you obviously will never be taxed on the vanished $60,000. On the other hand, if you recoup the $60,000 via short-term gains in your IRA, it is not taxed until you decide to withdraw it during retirement. Bottom line…by moving investments generating short-term capital gains into your IRA, you are foregoing the opportunity to recoup $1,000  in taxes ($3,000 x 33% tax bracket) for losses in order to benefit from tax deferred growth on taxes paid on short-term capital gains ($16,500 in 2012).

Consider for moment that there is no such thing as long-term capital gains or qualified dividends (taxed at 15-23.8% if held in a non-retirement account) in an IRA. When distributed, all income is taxed at ordinary tax rates.

Thus, when allocating your assets from a tax perspective, in a perfect world, your non-retirement accounts generate qualified dividends and long-term capital gains and tax-exempt interest. Your IRA investments generate short-term capital gains, nonqualified dividends and interest income (all taxed at ordinary tax rates if held in a non-retirement account).

One last thought…if the $50,000 short-term capital gain had incurred inside a Roth IRA…the tax consequences of the taxes saved (including tax deferred growth) when later distributed…zero!

By Don James, CPA, CFP

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About Don James, CPA/PFS, CFP
Don is the Tax & Financial Planning partner with Kiplinger & Co., CPAs headquartered in sunny Cleveland, Ohio since 1982. He partners with business owners and families and specializes in goal achievement solutions, tax minimization strategies and serves in the role of gatekeeper of sound financial advice.

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